Facebook in a Perfect World

24 July 2014


Using Google as a comp for future growth and valuation.

Facebook’s market cap is now very close to $200 billion. Its projected sales for 2014 are around $12 billion, which means that its stock is trading at over 16x forward sales. To many, this valuation seems justified by Facebook’s very high margins and growth rates.

For the sake of comparison, Google’s market cap reached $200 billion for the first time in 2007. Back then, its revenue growth rate was similar to that of Facebook today (not far from 60%) and its margins were slightly lower. Google stock in that year traded in a range of 8 to 14x sales, significantly lower than Facebook today.

Judging by what happened in subsequent years, you could say that Google’s 2007 peak valuation was justified. Since then, Google’s market cap has doubled to exceed $400 billion today. So if you are a Facebook bull, you can pencil in $400 billion as a target market cap and $150 target stock price.

The main problem with this logic is that things rarely evolve in a linear fashion. In other words, on the road to $400 billion and $150, we may first see $100 billion and $38.

An investor who bought Google stock in late 2007 and who held until today has outperformed the S&P 500 by a wide margin. But all of this outperformance has occurred in the 18 months from July 2012 to December 2013. In 2008, Google stock crashed like everything else, falling by two thirds, and its stock did not regain its 2007 high until late 2012.

Nonetheless, despite the 2008-09 crisis, Google sales continued to grow, albeit at a lower rate. Revenue growth was 56%, 31%, and 9% in 2007, 2008 and 2009. It reaccelerated in the subsequent years 2010-2013, to 24%, 29%, 32% and 19%.

  2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
 Google  92% 73% 56% 31% 9% 24% 29% 32% 19% 21%
 Facebook  37% 55% 65%

(Tables show 2014 year to date.)

As shown in the table, these are attractive growth rates but a far cry from what they were in the years to 2007. Even if you ignore the 2008-09 collapse, sales growth at Google has been on a long-term downward trend. It is very difficult if not impossible for a large company to maintain 50% growth rates.

  2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
 High  21.6 14.9 14.1 10.1 8.4 6.9 5.5 5.1 6.3 5.8
 Low  8.4 9.7 8.3 3.6 3.8 4.8 4.1 3.7 3.9 4.9
 High  21.0 19.0 16.0
 Low  8.2 7.3 11.2

Going back to Facebook, there are no doubt multiple justifications to hold the stock: the increased role of mobile, the potential for higher revenues per user, the integration of acquisitions etc. But a long position is betting on both flawless execution and a supportive macro environment.

At current valuations, the stock is priced for perfection not only at the micro level (its own operations) but also on the macro level (the overall economy and market). The odds are we will not see a major crisis like 2008 again soon, but what happens to Facebook stock if the economy slows down? Advertising is a notoriously cyclical business. What if Facebook’s own growth rate slows from 60% to a still strong 30%, as happened at Google? From a level of 16x sales, Facebook’s stock would certainly fall by 20%, 40% or more, depending on the severity of the slowdown.

Large Stocks Are Chronically Mispriced

11 July 2014


When investors influence each other’s decisions, the stock market becomes less efficient.


A different perspective

Conventional theory holds that the stock market is ‘efficient’ and that it does a good job pricing stocks at or close to their fair value, in particular the stocks of large widely followed companies. But could the opposite be true? Could it be that the larger and more followed companies are the less efficiently priced by the market? Could it be that their market value is chronically 20%, 30%, or 40% off from their fair value?

Here is the theory. Assume that there are only 1,000 investors who are active in the stock market and that they each independently derive a value for each stock in the S&P 500. ‘Independently’ here means ‘without sharing thoughts with each other and without letting themselves be influenced by other sources’. Under these admittedly improbable circumstances, the resulting level of the S&P 500 would be quite close to ‘intrinsic value’. We could say that the market would be ‘efficiently’ priced.

Now assume instead that the 1,000 are not working independently but that they influence each other, sharing valuation models, qualitative opinions, price targets, etc. Under these circumstances, the level of the S&P 500 would deviate, in some cases significantly, from its intrinsic value. The market would be inefficiently priced.

This at least is the theory and conclusion you can draw from some recent research on collective decision-making. A recent article titled When Does the Wisdom of the Crowds Turn Into the Madness of the Mob? explains it (my emphasis):

When can we expect a crowd to head us in the right direction, and when can’t we? Recently, researchers have begun to lay out a set of criteria for when to trust the masses.

Democratic decision-making works well when each individual first arrives at his or her conclusion independently. It’s the moment that people start influencing each other beforehand that a crowd can run into trouble.

Philip Ball, writing for BBC Future, describes a 2011 study in which participants were asked to venture educated guesses about a certain quantity, such as the length of the Swiss-Italian border:

“The researchers found that, as the amount of information participants were given about each others guesses increased, the range of their guesses got narrower, and the centre of this range could drift further from the true value. In other words, the groups were tending towards a consensus, to the detriment of accuracy.”

“This finding challenges a common view in management and politics that it is best to seek consensus in group decision making. What you can end up with instead is herding towards a relatively arbitrary position.”

If the research is valid, it debunks the idea that a widely followed stock is efficiently priced. It is not uncommon to hear someone say: “this stock is followed by so many people that I have no edge investing in it”? The opposite is almost certainly true: the more widely followed a stock is, and the more ‘influence’ is traded between the participants, the more certain you can be that its market price is wrong, and possibly wrong by a substantial margin.

Take Apple stock for example which is followed by a large number of analysts and investors. When it comes to AAPL price targets, can we say, to paraphrase the article, that the “range of their estimates got narrower, and the center of this range has drifted further from the true value?” And are investors as a group “tending towards a consensus, to the detriment of accuracy?” Investors tend to cluster their price targets not far from the current price which is now $95. But we can theorize that Apple’s intrinsic value is not $100 or $90. It is probably much further from its current market price, say $70 or $120.

Another conclusion can be drawn. When discussing their investment process, fund managers tend to put emphasis on the individual expertise of sector analysts and on their team’s collaborative discussions. In a typical model, the sector analyst will initiate an investment idea and pitch it to a fund manager or to a team who will then reach a decision on how to proceed. In this case, the sector analyst may have been influenced by his peers, by the sell-side and by other sources. And the deciding team members, while searching for a consensus, may have been influenced by each other, by the analyst, and by some willingness to defer to the analyst’s expertise.

If you believe the research described above, this is not the best approach to choosing investments for a portfolio. A better approach would be to have 5 or 10 analysts value the same stock independently, without looking at other sources. It might also be better if these analysts were generalists instead of sector specialists who may be biased in favor of their sector. Once the work is done, there is no point in having any discussions which may prove to be counterproductive. In theory, ‘discussion’ means ‘influence’ and it would result in more bad decisions. It is better to simply look at the valuations derived by these independent analysts. If the average of their price targets is way off the market price, it would be worth initiating a position.

Coach: Two Opposed Ideas

4 February 2014


Coach speaks the language of luxury but it is increasingly running a volume business.

F. Scott Fitzgerald wrote in The Crack-Up (1936) that “the test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function”.

Whether the same applies to corporate strategy can be the subject of doubt. But it is clear that Coach’s “one brand, two distribution channels” approach has not delivered the growth and earnings expected by shareholders. Coach is trying to elevate its brand in one channel, full price stores, while at the same time unwittingly depreciating the same brand through another channel, factory stores. An outside observer can be forgiven for viewing these efforts as “two opposed ideas in the mind”.

The most successful companies tend to have a clear unambiguous mission and message. But Coach appears to be, on many levels, a company that is mired in ambiguity, or even confusion, which explains why its stock has drifted aimlessly for over a year while peers Michael Kors (KORS) and Kate Spade (FNP) have scaled new highs.

Here are a few questions about Coach, with ambiguous answers:

- Is Coach a luxury goods company?

Yes. Its handbags come with a quality and price tag (several hundred to over a thousand dollars) that put them in the category of luxury for most consumers. It has “full price stores” in prime locations such as New York’s Fifth Avenue. Coach offers accessible luxury at a price point where the European luxury players cannot compete effectively.

No. Coach’s pricing is far below that of European über luxury names like Hermès, Bulgari or Louis Vuitton. Coach derives two thirds of its North American sales from lower-priced sales at factory outlets. That is nearly half of total sales, a percentage that is too high for a true luxury company.

In addition, Coach runs too many discounted sales for a luxury company. Between Thanksgiving Week and the end of the year, I counted no fewer than a dozen discounted sales on Coach’s Twitter account. (Side note: It is not clear why Coach advertises some of its discount sales as “Semi-Annual”. This practice encourages some customers to just wait a few months for better prices).

Semi-Annual Sale

Coach Stock: Another Semi-Annual Sale

- Will Coach be a growing company again?

Yes. The company is seeing rapid growth in its men’s line and in international sales, most notably in China. International comps will improve in 2014 as the Yen’s near-30% decline phases out gradually. An acceleration in the US recovery will help North American sales rise again.

No. North America sales are in decline due to structural, not cyclical, reasons, in particular the aging of Coach’s customer demographic.

- Does Coach have a strong management team?

Yes. Coach is highly profitable, generates strong cash flow and has no debt. Management has taken decisive steps to develop new revenue streams. For example, the men’s line now accounts for over 10% of total sales. And sales in China are booming.

No. Coach was too slow to develop a foreign presence. In North America, an overreliance on factory outlets has damaged the brand. And the effort to transform Coach into a broader lifestyle brand raises its risk profile since it is no longer just “sticking to its knitting”.

- Is Coach still a hot brand?

Yes. Coach’s new creative director, Stuart Vevers, will reinvigorate the brand with new products that will be introduced this week at Fashion Week in New York.

No. Michael Kors, Tory Burch, Kate Spade are the new hot brands. Coach is associated with an older demographic and is past its prime. It will be difficult to rejuvenate the brand.

- Is Coach a good investment?

Yes. It has a low valuation and strong cash generation. Growth will return in 2014. The disconnect between valuation and profitability will correct itself through a rise in valuation.

No. North America will remain a problem for a long time and margins will continue to erode. The disconnect between valuation and profitability will correct itself through a decline in profitability.

Scale vs. Exclusivity

Adding to the confusion are some statements by Coach executives in recent weeks. Here are two examples:

Francine Della Badia, President of North American Retail, at a Morgan Stanley Conference (full transcript here): [my emphasis]

“We’re very proud of our factory business and our factory consumer, and if you think about economics alone, there is more scale available to us to participate in a handbag category that’s under $300 than at our full-price average unit retail of $300. So I love our factory business, I’m very proud of our factory business.”

If I am interpreting this message correctly, Ms. Della Badia is saying that Coach can make more money selling a large number of sub-$300 handbags at factory outlets, than a smaller number of higher priced handbags at full price stores. This is disconcerting talk from a luxury goods company.

But it fits a now familiar pattern: Coach likes to speak the language of luxury but it is largely pursuing a mass-market volume strategy. Coach continues to open new stores at factory outlets.

The second statement is from Coach’s recent earnings call in which Kimberley Greenberger of Morgan Stanley asked whether the outlet business damages the brand. Although we all know the straight answer to this question, the circuitous response offered by new CEO Victor Luis was revealing (full transcript here): [my emphasis]

GREENBERGER:  “Victor, you mentioned the endeavor to restore brand equity, and I’m just wondering, how do you think about that effort over time with the ongoing increase in square footage in factory? It would seem in some ways that those two things worked against one another, given that typically expansion in factory is not really brand enhancing. It certainly increases distribution opportunity, but having more discount product out in the marketplace would not really seem to be congruent with the effort to restore brand equity. So I’m just wondering if you can help us with how you think about those two opposing forces.”

LUIS: “It’s obviously a question we get often, and what I would share is that we believe the brand, first and foremost, must be led through the full price channel. And what you see, again, in Lower Fifth, what you see in South Coast Plaza, in terms of a direction for the future of our fleet and the equity that we want to drive through that fuller lifestyle experience, where consumers are engaging with the brand differently, without a doubt will be both a business driver but just as important, if not more so, the halo for the entire multichannel strategy that we have.”

“Outlets, in terms of their importance globally, are unquestionably the fastest growing certainly bricks and mortar channel in the luxury space. That is not only true for U.S. based multichannel brands. It is increasingly true for European and traditional luxury brands who are driving further relevance for the channel globally, whether it be here in the U.S., where it’s quite a mature channel, but of course increasingly in Europe, and now, more than ever, increasing in China and the rest of Asia as well. And so as that channel grows, we want to make sure that we participate in it, and take our fair share there.”

And further:

LUIS: The key is not just to see it as a promotional channel, but to see it as a channel which is of relevance to a certain consumer, who does not shop in other channels, and where we have the leadership position and see continued growth moving forward.”

What Mr. Luis is saying, again if I am interpreting this correctly, is that the full-price store is an important driver of the company and “just as important, if not more so”, it is a place to valorize the brand and the factory outlet business. If this means that the luxury higher end business is an important place to advertise the factory outlets, then we are in tail-wags-the-dog mode with full-price stores seen as essential to boost factory sales, instead of factory stores seen as an unfortunate but needed outlet to clear some excess inventory.

Both Ms. Della Badia’s and Mr. Luis’ statements indicate that the factory store is one of the company’s core businesses, if not the main core business. But this business poses a threat to brand equity, to growth and to profit margins.

Losing Exclusivity

Coach’s strategy dilutes its “exclusivity”. In a recent study on the global luxury industry and survey of 10,000 core luxury consumers, the Boston Consulting Group (BCG) and Altagamma indicated that 25% of luxury brands are at risk of losing their exclusivity. Antonio Achille, partner and managing director at BCG, said this: [my emphasis]

“Exclusivity is a core attribute that a brand and a product must have for core luxury consumers. Brands need to recognize that there are several ways to lose exclusivity, some of which can be only partially controlled, such as fake copies, but others are in control of the brand, for instance, discounting too often, too intense use of licenses or poor distribution. Once exclusivity is lost, the equation to rebuild it is very complex, takes time and there is no guaranteed success.

In my last article on Coach, I speculated that it may be the target of a takeover. Since then, the stock has made a round trip from the high 40s to the high 50s and back. This is yet another iteration in a tug of war between some investors who have given up and others who keep waiting for Coach to perform.

Fitzgerald’s next sentence in The Crack-Up was: “One should, for example, be able to see that things are hopeless and yet be determined to make them otherwise.”

Will Coach shareholders make things otherwise?

P.S. Michael Kors reported another stellar quarter this morning.

Disclaimer: The views expressed here are not intended to encourage the reader to trade, buy or sell Coach stock or any other security. The reader is responsible for any loss he may incur in such trading.

Euro: Austerity, Breakup or Devaluation?


In a new book, Nomura’s lead currency strategist warns that the Euro is on an unsustainable path.

“I wrote this book because I care about Europe”, writes Jens Nordvig in the preface to The Fall of the Euro.

This passion and the author’s scholarship shine through in the subsequent pages. European by birth and living in New York, Nordvig, who is Global Head of Currency Strategy at Nomura, has a unique understanding of the factors that led to the creation of the Euro, and of the impact that the Euro crisis has had on financial markets.

He also has some unsettling insights about the future.

Breakup or Exit

Many people have speculated on the breakup of the Euro. But is a breakup feasible?

Legally speaking, It would be relatively easy for each Eurozone country to redenominate the Euro assets and liabilities which are within its jurisdiction back to its national currency. But, writes Nordvig,

“What would happen to financial assets and liabilities that were outside the jurisdiction of the Eurozone countries if the euro ceased to exist?… What would happen to a loan made in euros by a US investment bank to a big industrial company in Poland? Would the loan now be in US dollars? Would it now be in Polish zloty?… The lender might have one preference and the borrower another. There would be a potential dispute of this nature for every single financial contract…These disputes would be the catalyst for widespread legal warfare…There would be trillions worth of assets and liabilities denominated in “zombie euros” and outside the reach of Eurozone governments… There was no example of this in history.”

If the obstacles to a full breakup seem insurmountable, the exit from the Eurozone by one or several countries look by contrast to be more manageable. Here as with many Euro-related decisions, the outcome will likely be dictated by politics.

Although the weaker countries are seen as likely candidates for exit, Nordvig notes that any benefit they would derive from reverting to their weaker national currencies would be largely offset by the magnified burden of having to service their Euro-denominated debts.

Nordvig also explores the scenario of a German exit, an option which he views as feasible but improbable.

Austerity or Devaluation

A “hard currency equilibrium” has prevailed since 2012 but this equilibrium is entirely dependent on periphery countries (Italy, Spain, Portugal, Greece, Cyprus) sticking to tough austerity measures. In this scenario, adjustment will take several years before a strong recovery can return.

Should austerity prove unsustainable, the Euro may find a “soft currency equilibrium” in which debt limits are ignored and rescue conditions are relaxed. According to Nordvig, this could turn the Euro into a weak currency not dissimilar to the former Italian Lira.

Bond spreads have tightened and stocks have risen since the dark days of 2012 but Nordvig cautions against complacency:

“Investors should be on the alert and not be fooled by the relative market calm observed since the summer of 2012. There is a difference between bond yields that are consistent with fundamentals and yields that have been artificially pushed lower as a result of insurance from the core.”

Coach: Ripe for Takeover?


(also published at Seeking Alpha)

“International sales decreased slightly…”

That’s a sentence you do not want to see when you are looking at a company which is viewed by many as a significant player in the booming global luxury goods sector. And yet, there it is, in Coach’s first quarter report released a few days ago. To be fair, the slight decrease in sales was due to rare and large currency fluctuations. The dollar rose by 27% against the Yen in the last year, an extreme move not often seen with major currencies. On a constant currency basis, international sales rose 9% in the quarter, which is reasonable but not a barn burner. A bright spot was China where sales boomed 35%. So there was some good news behind the headline.

Despite the Q1 disappointment, Coach’s net income and free cash flow margins remain strong. Its main problem is not profitability but the fact that North America contributes 67% of total revenues and has essentially gone ex-growth.

If you put Coach in the bucket of luxury goods companies (which are mostly European), it is clear that Coach is badly underperforming. Sector peers LVMH, Burberry, Richemont and others have zoomed ahead with sales, profits and stock prices not far from their all time highs. The main reasons for their greater success have been their more aggressive expansion into Asia and stronger brand management.

But if you put Coach in a more general bucket of consumer and apparel companies, then it is doing better than some and worse than others. The issue however is that the company’s future will be largely determined by which bucket it puts itself in. As a luxury goods company, it can maintain some pricing power and it will preserve or raise its margins and market value. It could also merge with or be acquired by one of the Europeans. But as a general consumer company, its brand will get tarnished. Its margins will continue to erode and so will its valuation.

Coach’s problems can therefore be summed as follows:

-          An insufficient geographic footprint outside the US.

-          A large North American presence which has stalled.

-          A brand that is in danger of falling out of the “luxury” sector.

The store opening program can be accelerated overseas if there is sufficient confidence that the luxury boom will continue. Coach has a strong balance sheet and is generating positive free cash flow. In theory, therefore, it has important untapped reserves which it can deploy to open stores at an accelerated rate.

North America will be more difficult to fix, given intense competition from the likes of Michael Kors and Kate Spade. Here, design appeal and brand management are key to an eventual recovery. Coach faces the risk of what the French call “Cardinisation”, the fate met by the Pierre Cardin brand when it became so ubiquitous that it lost its luxury stamp.

In this sense, the fact that 60% of Coach’s North American sales occur in factory outlets is positively troubling. Sales at these outlets come at better margins because of lower costs and higher volumes but they damage the brand and could reclassify it outside of the luxury sector. And that could be the beginning of a death spiral for pricing.

A quicker fix would be to sell the company to another luxury goods firm. An acquirer who already has a large presence in Asia and Europe could quickly boost Coach’s overseas revenues and lower its costs. Conversely, Coach’s large US presence could be of benefit to an acquirer looking to grow its own American sales. One problem is that a buyer may initially look to strengthen the brand by closing some factory outlets. This could reduce North American volumes in the near term, a consideration which may depress any proposed takeover premium.

So is this a good price to buy the stock?

Yes, because international sales growth will soon return and for the possibility of a takeover.

No, because branding issues and North America are unlikely to be resolved in the next quarter.

All in, it is a buy for speculative portfolios. More conservative investors should look to buy at a lower price if the company takes steps to avoid further erosion of its margins and to move its brand upscale.

Note: Last year, I wrote more generally about prospects for the luxury goods sector.

Disclaimer: The views expressed here are not intended to encourage the reader to trade, buy or sell Coach stock or any other security. The reader is responsible for any loss he may incur in such trading.

Weak GDP Growth Reflects Poor Demographics

26 June 2013

GDP growth for the first quarter was only 1.8%, less than the expected 2.4%. Since the recession of 2009, the recovery has been anemic compared to previous ones. See table below. There are some features which differentiate the 2008-09 recession. Most notable among them was the crisis suffered by the major banks and their subsequent inability or reluctance to lend. Another factor in the current recovery, and in our view a more substantial one, is the poorer demographic picture in the US which has resulted in weaker demand growth.

 Number of quarters with n+ GDP growth
 in the 15 quarters following recession of:
n —-> 2% 3% 4%
1991 12 8 7
2001 11 7 2
2009 8 3 2

31 July 2013 Update: GDP growth for Q1 was revised down again today to 1.1%, less than half the estimate from two months ago.  The first estimate for Q2 is 1.7%.

Nokia: The Path To Recovery


(also published at Seeking Alpha)

What this country needs is a good $99 smartphone.

That’s what Thomas R. Marshall, Woodrow Wilson’s Vice-President (1913-1921), might have said today instead of ‘a good five-cent cigar’. Smartphones are still very expensive, at least at the pre-subsidy price. Carriers pay over $600 for top-end phones and ‘subsidize’ customers who pay a discounted price if they commit to a multi-year wireless plan. But prices are destined to fall in the next few years. Within a decade, we could be looking at a $99 phone (pre-subsidy) which will approach the same functionality as today’s flagship phones.

Regarding their competitive strategy, there are two ways for smartphone producers to deal with this evolution.

1. A Top Product Strategy

One way is to start at the top with the best possible product and to continually improve its features. The flagship phone produced by each company can then remain at prices similar to today’s prices but its capability will grow year after year. This seems to be the strategy followed by Apple with each of its product lines. Each has a similar price as a few years ago but its functionality is much greater.

This strategy however has its limitations: at some point, whether it is in 2013 or in 2018, a majority of the buying public will not care as much about new features because the new phone’s capability will far exceed whatever need or use the consumer may have for it. Adding music and cameras was huge. Adding wifi was huge. Adding apps was huge. At some future date, they will be adding things that only tech geeks, or the few people who use their phones’ full capability, really care about. Even within the apps catalogue, most of us will truly care about only a dozen or so. And most of us are rarely more than thirty minutes away from our personal or work desktop computers. There are truly very few apps we ever need to use urgently, in less time than it takes to reach a desktop.

For companies with a product strategy, it is a challenge to keep people interested in new features. And it is a race against time to release these features on a schedule which will preserve high prices and high margins. In most such races against time, time ends up winning.

2. A Bottom Price Strategy

The other way for smartphone producers to deal with new competitive pressures is to start from the bottom with a preset price for a phone and to see how many features can be packed in at that price while the phone is still profitable. So say a company chooses $99 as a price before subsidies and it sets out to discover how good of a phone it can deliver at that price. The first few phones priced at $99 will look very inadequate. But here, unlike with a product strategy, time is an ally. The more time goes by, the better the $99 phone will become. In the future, a $99 phone will be as good as an iPhone 5 or a Samsung Galaxy S4.

Asha Rising.

Asha Rising.

The question then is which company would you rather be? Would you rather be the first company racing against time trying to slow down margin erosion by offering more and more features, while hoping that customers will still want them? Or would you rather be the second company, with time as an ally, securing a growing segment of customers who want a low price and who only use a few apps on a regular basis? In the early days of the smartphone, when new features addressed important market wants and needs, I would have to put my money on the first company and it made sense to invest in Apple. Going forward, I would have to put my money on the second company.

Industry Shift to Dumb Smartphones

This is where Nokia could make a strong comeback. I have no idea whether it will pull it off, but it has a plausible path to recovery. Nokia lost the first smartphone round to Apple and Android. It could gain market share in the high end with its Lumia Windows Phone 8 phones but this looks like a difficult proposition, as noted by many authors here. It is not enough for the Lumia flagship to be as good as a top Apple or Android phone; it has to be significantly better or its price has to be much lower to compensate for consumers’ inertia, brand loyalty and switching costs. You may not consider a top Lumia phone if it is $50 cheaper than an iPhone but you would consider it if it was $100 cheaper and if you are not too rooted in the Apple or Android ecosystem.

Within the Lumia range, Nokia recently introduced the Lumia 521 priced at $150 with no contract, but its margin on this phone is probably low, or possibly negative. The challenge for a ‘bottom price strategy’ is to deliver a low-price phone which is still profitable for the manufacturer. Entry level phones like the Lumia 521 may be unprofitable and positioned as loss leaders to gain market share and to attract buyers in the hope that they will later migrate up to more profitable phones.

Generally speaking, when comparing Lumia to iOS (Apple) and Android (Samsung and others), there is rarely room for a number three to prosper in a space that is dominated by two aggressive well-financed players. Lumia has been gaining market share but it has yet to break into double digits.

Instead of banking too much on Lumia, Nokia can instead win the next round when prices start to fall quickly, or to put it differently, when the functionality of inexpensive phones starts to rise quickly. That is why, of Nokia’s two recent phone launches, the Asha 501 was in my view the more exciting. Not because of the phone itself, but because of the strategic shift it may bring. While the industry’s heavyweights are battling to claim the title for the smartest smartphone, an increasing number of consumers will be satisfied with a low-priced ‘dumb smartphone’.

The Asha 501 is priced at $99 and its functionality is very limited today. See CNET’s video review of the Asha 501 and a review by TechCrunch. But as noted above, its capability is only going to improve in coming years. Launched in India, it will ship in June via 60 carriers in 90 countries, mainly in emerging markets and Europe, but not the US. Instead of Windows Phone, it uses the Smarterphone OS, a stripped down operating system, and runs on 2G GSM networks. Not exactly the kind of stuff that would get an American buyer excited. But at a future date, Nokia may be able to launch a much improved low-priced phone in the US. Of course, Apple and Samsung can do the same but they are hamstrung by their high stock prices and the market’s expectation that they will maintain strong margins. Nokia has no such “problem” since its stock and margins are now distressed. Low expectations can sometimes be an advantage. (The same applies to other players who have fallen behind and have little to lose.)

To be sure, there are already lower priced or even free iOS and Android phones sold by the US carriers. For example, AT&T sells the 8GB iPhone 4 for 99 cents + an activation fee of $36 and a two-year contract. But a $99 price for an Asha-like phone, pre-subsidy or without contract, would still be significantly cheaper. AT&T sells the iPhone 4 without contract for $450.99.

In recent years, the key success factors in the smartphone business were product and technology. As prices tumble and consumers’ appetite for more functions start to fade, the new success factors will be price, manufacturing and logistics, all factors at which Nokia has excelled in the past. Perhaps it can do it again. If it does not, someone else will.

Disclaimer: The views expressed here are not intended to encourage the reader to trade, buy or sell Nokia stock or any other security. The reader is responsible for any loss he may incur in such trading.

Market Is Approaching Reversal

Although technical analysis has severe limitations, it can be useful for near-term market forecasts. Judging from the chart of the S&P 500, a simple ascending channel seems to have worked well to predict index reversals between 2003 and 2007. That is true for the overall period, and also for a sub-channel in 2004-2006 (not shown). Like an object pushed along a frictionless surface, the market will keep on going in the same direction until another major force intervenes to push it in another direction. Technicals can then be useful to define the shorter-term limits of such a multi-year move.

S&P 500 2003-2007

S&P 500 2003-2007

Looking at the present, we can see that the index is approaching a level at the upper boundary of the channel where it is likely to reverse. Extending the channel to year end, we can say that, in a bullish scenario, the S&P 500 will end 2013 near 1,800. In a bearish one, it will fall to 1,400. That’s a wide range and therefore not a useful prediction. But it may help determine near-term reversals when the index approaches these limits.
S&P 500 2009-2013

S&P 500 2009-2013

Another technical indicator is also bearish. According to Bloomberg News, 82% of S&P 500 stocks are now trading over their 200-day average, compared to an average of 54% since 1994.

Europe: Was (Is) It Worth The Trouble?


(also published at Seeking Alpha)

No for indexers. Yes for macro trend investors. Maybe (but probably not) for bottom-up stock pickers.

European stocks face a unique situation, which is that, outside of the rolling debt crises from Ireland to Iceland to Greece to Spain, their performance has been, and will continue to be, driven by macro factors emanating from outside the European Union.  This is mainly because Europe itself has the worst demographics of any region of the world with declining or stagnant populations in several countries and rising dependency ratios (dependents per worker) in all countries (see tables or, for more on demographics, see Demographic Megatrends of the 21st Century).  Therefore, except for the cyclical recovery which may or may not show up this year or next, the longer-term prognosis for domestic demand growth is far from encouraging for a large majority of European companies.

UN   Estimate Total Fertility Ratio Population (millions)
  2010 2030 2050 2100 2010 2030 2050 2100
 France 1.99 2.04 2.06 2.09 63 68 72 80
 Germany 1.46 1.74 1.9 2.05 82 79 75 70
 Italy 1.48 1.75 1.91 2.05 61 61 59 56
 UK 1.87 1.97 2.03 2.08 62 69 73 76
 Europe  1.59 1.82 1.93 2.06 738 741 719 675

These estimates are from the United Nations medium variant. Note how the dependency ratio declined for the past four decades and is now expected to rise in the next four.

 Dependency Ratio 
1950 1970 1990 2000 2010 2015 2020 2030 2050
 Europe 52 56 50 48 46 50 54 61 75
 USA 54 62 52 51 50 53 56 64 67

It is fortunate therefore that Europe has some tremendous companies, large and small, which are global leaders in their sectors and which can find growth outside of Europe’s borders.  A large number of these companies have had a very strong performance in recent years thanks to slow growth in the US and fast growth in emerging markets, in particular China. Good examples are iconic automaker BMW, luxury goods powerhouse LVMH, chemical giant BASF, retailer Hennes & Mauritz and many many others.

(Note: stock tickers not shown in the text are shown in the tables, using the Bloomberg convention)

Some of these winners have been smaller companies. Consider for example the Finnish tire company Nokian Tyres (NRE1V FH) spun off from Nokia (NOK1V FH) in 1995. Although Nokia has for years been followed obsessively by investors, it is Nokian Tyres which has outperformed Nokia proper by a stunning margin over the past seventeen years (except for 1998-2002 and 2008-09) logging in a nosebleed gain of nearly 4900% since the spinoff vs. Nokia’s decidedly paltry cumulative 11.3% (excluding dividends). Even if you exclude Nokia’s decline after 2007, the outperformance would still be very large. (Note to Apple AAPL watchers: it may be better to look elsewhere).

In the 1990s, there was much talk of the benefits to investors from geographic diversification. Academic research made a case that greater returns could be achieved with less volatility, a case which was then amplified in the financial media by large mutual fund companies. It is not within my scope to rebut this case from a theoretical perspective. For the next section however, I looked at the numbers empirically and they show that a multi-country European stock index would have underperformed the US or other global markets in the past ten and twenty years. In many periods, this underperformance was not accompanied by a correspondingly lower volatility. In fact, the volatility of European markets in 1996-98 and 2005-08 seems to have been higher. A European indexed fund or ETF (VGK, IEV), to put it plainly, was simply not worth it.

Because the vast majority of mutual funds underperform their benchmark index, you could also say that European mutual funds were not worth it.  In the event of a large deviation between a foreign stock fund and its benchmark, such deviation could usually be explained by currency moves rather than the fund managers’ skill at selecting a portfolio of superior stocks.  This was certainly the case in the 2003-07 bull market when US dollar weakness greatly helped all funds which were not fully currency-hedged. Here the financial media usually gave all the credit to the fund managers’ superior stock selection (often alleged) and not enough attention to the currency moves (always real).


European stock indices usually move in step with the US market.  This is not true in every single year but it is true in most years and on a multi-year basis if not in magnitude, certainly in direction. Going back ten years, the European markets moved roughly in line with the S&P 500 except for 2005 when the European index outperformed by a wide margin, and 2010-2011 when the S&P 500 outperformed for two years in a row.

As things stood last December 31st, Europe had returned 38% in a decade and the US 62%. Much of this underperformance can be attributed to the strengthening of the Euro which nearly doubled against the US dollar in 2001-2008. A strong Euro/weak dollar is detrimental to European indices which are heavily weighted with exporters. A dollar-based investor in Europe who did not hedge out the currency would have benefited from the stronger Euro and would have recorded, in the decade ending on December 31st 2012, a gain of 67% from European indices, marginally better than the S&P 500.  On a twenty year basis, the European index returned 162% for a currency-hedged investor and 196% for an unhedged investor, in both cases less than the S&P 500 which returned 227%. (These returns and the ones shown in the table do not include dividends).

Nonetheless, the overall European index (I use MSCI Europe) masks important differences between countries.  Although the EU has gone a long way to reduce these differences, they continue to be relevant because regulation, taxation, work ethic and basic business practices remain largely country-specific. It is trite to say that Germany is the uncontested leader in Europe, but it has emerged by now in early 2013 as the primary beneficiary of the Euro project.  I made a case here that Germany should in a strange way be thankful for Greece, because it is the presence of Greece (and Italy and Portugal) within the Euro sphere which has kept the Euro at a level that is weak enough to help German exports and to sustain the German economy on a growth path.  Without the Euro, the Deutsche Mark would have been stronger against other leading currencies and Germany’s economy would have probably fared worse than it did.

Twilight or sunrise?

Twilight or sunrise?

When you look at country indices going back two decades, a few things stand out quickly. First, the US, UK and Germany have recovered nearly all their losses of 2008-09, whereas France, Spain and Italy have not.  Second, Germany has outperformed the US by a wide margin in the past ten years and in the past twenty years. Spain has also outperformed the US in the past twenty years but that is mainly due to the first decade 1993-2002 when the Spanish stock market, along with Italy, was a huge beneficiary of the convergence trade preceding the adoption of the Euro.  The UK has lagged the US and Germany but has done better than France in the more recent decade.  All in, of the large markets, Germany stands out as a big winner, Spain a winner only in the first decade, Italy as a big laggard, and France and the UK somewhere in between.

The smaller Nordic markets have done exceedingly well over the past two decades.  Norway was greatly helped by its exposure to oil and oil services in the past decade.  Sweden and Denmark did very well in both decades thanks to stellar performers Hennes & Mauritz, Atlas Copco, Novo Nordisk (NOVOB DC) and TopDanmark (TOP DC). Finland’s index benefited from Nokia’s large market cap weighting in the 1990s and suffered from it in the last five years.  Ex-Nokia, the Finnish index would in fact show an impressive performance in recent years. On the two decades 1993-2002, Finland is still the best European performer by far. Like Germany, it has many world-class exporters.

 1993-02  2003-12 1993-12 2003-07 2008-12
 USA  S&P 500 101.9% 62.1% 227.3% 66.9% -2.9%
 Europe Local  MSCI 89.8% 38.2% 162.3% 85.9% -25.7%
 Europe USD  MSCI USD 77.9% 66.7% 196.4% 144.5% -31.8%
 UK  FTSE 100 38.4% 49.7% 107.2% 63.9% -8.7%
 Germany  DAX 30 87.2% 163.2% 392.7% 178.9% -5.6%
 France  CAC 40 64.9% 18.8% 96.0% 83.2% -35.1%
 Spain  IBEX 157.5% 35.3% 248.4% 151.5% -46.2%
 Italy  FTSE MIB 138.9% -30.8% 65.3% 62.8% -57.8%
 Switzerland  SMI 119.8% 47.3% 223.8% 83.2% -19.6%
 Netherlands  AEX 148.8% 6.2% 164.2% 59.8% -33.6%
 Sweden  OMX 174.6% 124.0% 515.0% 119.3% 2.2%
 Norway  OBX 320.0% 332.0% -2.8%
 Denmark  OMX 166.8% 148.7% 563.5% 132.7% 6.9%
 Finland  OMX 596.7% 0.5% 599.8% 100.8% -50.0%
 Brazil  Bovespa 166089.0% 440.9% 898832.0% 467.0% -4.6%
 Brazil USD 111.3% 836.5% 1879.1% 1030.2% -17.1%
 China  Shanghai 74.0% 67.1% 190.8% 287.6% -56.9%
 Hong Kong  Hang Seng 69.1% 143.1% 311.0% 198.4% -18.5%
 Japan  Nikkei 225 -49.3% 21.2% -38.6% 78.4% -32.1%

Among emerging markets, Brazil was a very strong performer.  The Brazilian Real’s devaluation against the US dollar in the 1990s explains much of this performance.  But Brazil has been one of the best global performers even on a dollar basis.  China has had a respectable performance, but perhaps one more muted than many would have guessed from the steady barrage of headlines about the rise of the Chinese superpower. And Japan as we know has been a dismal place to be an indexed investor, except for brief spurts in the mid-90s and in 2003-07.

Net net Europe has underperformed the US on both a one decade and a two decade basis whereas several emerging markets have performed in line or much better than the S&P 500.  All of this may be discouraging if a person worries about the indices too long. But for those who ignore the indices, Europe offers outstanding opportunities.


After the closet indexers have left the room (or clicked away from this page), we can now talk about two incontestable reasons to invest in Europe: 1) an early warning system and 2) a leveraged play on other markets or trends.

Europe as an early warning system

The first reason is that early signs of an impending crisis often emerge in Europe before they do in the US. This is true not because Europeans are more prescient than Americans, but because their stock market is more fragmented into individual countries.  It would be the same here if each state of the United States had its own stock market.  In that case, we might have , for example in 2007, picked up on signs of distress in the subprime market through the Arizona, Nevada or Florida stock markets several months before they became visible in national indices temporarily held up by other, more buoyant sectors.

If a manager has some holdings in Europe, he is likely to pick up on signs of trouble before his competitors do and long before they appear in the major headlines. This was certainly true in 1997 and 1998 when European banks with large exposures to faltering Asian markets and to Russia telegraphed signals to the bullish markets in the late spring and early summer that all was not well. And it was also true in 2000, when stodgy companies like Alcatel (ALU FP) and the old state-owned telecom operators were trading at very inflated multiples normally reserved for hot new companies coming out of California.

This ‘Europe as an early warning system’ delivered again in the crash of 2008, in particular for people who were paying attention to Ireland. The S&P 500 recorded a small gain in 2007 but Ireland which had wholeheartedly embraced the housing bubble saw its index fall by 27%. Italy too was down in that same year, but by a less alarming 7%.

When the US subprime crisis erupted in 2007 and 2008, there was in Europe widespread belief and barely concealed schadenfreude that the Americans, already out of favor on the continent because of the Iraq war, were getting their comeuppance and that Europe, reinforced by a growing Euro sphere and a billion eager Chinese customers, could now promote its economic success as a new model for other countries. As we know, reality came back unsparingly when all Euro markets crashed in late 2008.

In 2011-12, the US market was to some degree driven by the daily news flow from Greece, Spain, Italy and other parts of Europe. For a while, exploding sovereign yield spreads threatened to throw in reverse the conversion trade of the late 1990s and to tear the Eurozone apart. And now Europe has combined bailouts and austerity and the US has combined bailouts and stimulus, with the net result that Europe is in recession and the US is growing modestly. In the coming years, it will still be a good idea for US investors to keep an eye on Europe, even if its importance has diminished in the global sales mix of American companies because of emerging markets.

I recognize that getting an early distress warning is by itself an insufficient reason to draw investors into Europe.  Insurance is a good idea but no one wants to overpay for it or feel that it has become a distraction. A larger and more positive reason to invest in European stocks is that they offer an excellent way to get exposure to other markets.

Europe as a leveraged play on other markets

Investing in Europe to get exposure to other, non-European, markets and trends can be exceptionally rewarding.  Most of the news that may push many large and midsize stocks higher or lower comes from outside of the European continent, chiefly from the US and China.

Exposure to the US dollar and US economy

Until China became a major source of export demand for European goods, the US economy was the most important driver of earnings growth for a large number of European firms. For this reason, the exchange rate of the dollar vs. European currencies was an important factor in the earnings of these companies. European stocks were a leveraged play on the US dollar. If the dollar moved 5%, some stocks would move 10 or 20%. It is true that you could instead invest directly in the currency markets but stocks gave you more leverage and also gave you the possibility of gaining from periodic efforts to create shareholder value. In the 1990s, for example, you had a wave of restructurings, followed by the tech boom. In the 2000s, you had the commodity boom and the rise of emerging markets.

Exposure to the Chinese economy and other emerging markets

Europe’s relationship to the US dollar and US economy still exists but it has been diluted by the rise of another very large client, the Asia-Pacific region. For a majority of large and midcap European companies, the Asia-Pacific region has replaced the US as the main source of sales growth. China and Japan are obviously the two main poles of demand, with China showing by far the fastest growth rate in the sales mix of European firms. One of the best ways to get exposure to the growing Chinese economy has been through a portfolio of European exporters which are global leaders in their industries.  In fact, such a portfolio would have handily outperformed the stock markets of China and Hong Kong in recent years. This may not be intuitive but investing in European exporters has been one of the best ways to invest in Chinese growth.

Nowhere is this more true than in luxury goods and prestige brand companies which have seen a growing percentage of their revenues coming from the Asia-Pacific Region. Luxury goods companies Hermès, Richemont and Swatch now have about 50% of their sales in that region.

 Luxury & Spirits     Market Cap   AsiaPac % 
     Billions USD   2011 Sales 
 Burberry  BRBY LN           9.49 34%
 Campari  CPR IM           4.44
 Diageo  DGE LN         74.33 10%
 Ferragamo  SFER IM           4.44 34%
 Heineken  HEIA NA         42.50
 Hermes  RMS FP         35.91 46%
 LVMH  MC FP         91.18 27%
 Pernod Ricard  RI FP         33.49 39%
 PPR  PP FP         27.16 24%
 Remy Cointreau  RCO FP           6.46 39%
 Richemont  CFR VX         46.74 51%
 SAB Miller  SAB LN         79.62
 Swatch Group  UHR VX         29.85 54%

European companies are by far the world leaders in luxury goods, and the French among them own some of the strongest brands. LVMH is the largest luxury goods company in the world, with an extensive portfolio of brands, including Louis Vuitton, Bulgari, Dom Perignon and Tag Heuer (see full list of LVMH brands here).  France also has Hermès and spirits companies Pernod Ricard and Remy Cointreau. Switzerland has the Swatch Group, the parent of Blancpain, Breguet, Omega, Glasshutte and, as of this year, Harry Winston (see Swatch Group brands here). Also in Switzerland is Richemont, the parent of Cartier, Montblanc and Vacheron Constantin (see Richemont brands here). Italy has Salvatore Ferragamo, spirits company Davide Campari, eyeglass leader Luxottica (LUX IM) and leather company Tod’s (TOD IM). Germany has automotive luxury with BMW, Porsche, Audi and Mercedes.  Porsche and Audi are part of Volkswagen, and Mercedes is part of Daimler (DAI GY). All of these countries also have many more luxury goods companies which are not publicly listed. I have also written about the luxury goods market in BMW, Louis Vuitton, Swatch: Can the Boom Continue?

The US is active in many of these sectors but has few dominant companies.  Coach (COH) and Tiffany (TIF) offer excellent products but cannot match the pricing power, brand supremacy, geographic footprint and cash flows of Hermès, LVMH or Swatch. US firms have also enjoyed better growth in their home market and have not felt the need to expand into the Asia-Pacific region as aggressively as the Europeans have.

Another sector which has benefited from the growth of emerging markets is industrials.  Here too, Europe has some global leaders in autos, chemicals, machinery, industrial gases, aircraft and heavy trucks. In the first nine months of 2012, for the first time ever, BMW sold more cars in China than it did in the United States.  BMW also owns Rolls Royce cars and the Mini brand. And Volkswagen in 2012 delivered nearly four times as many cars in the Asia-Pacific region as it did in North America. All three of BMW, Volkswagen and Daimler are present in both the luxury sector and the industrials sector: BMW through its own brand, Rolls Royce and Mini; Volkswagen through its own brand, Porsche, Bentley and Audi and its ownership stakes in Scania (SCVB SS, 46% of capital) and in MAN (75%); and Daimler through its Mercedes cars and trucks and Freightliner trucks.

Industrials   Market Cap AsiaPac %
    Billions USD 2011 Sales
Air Liquide AI FP          38.73 22%
Assa Abloy ASSAB SS          14.86 9%
Atlas Copco ATCOB SS          34.79 28%
BASF BAS GY          89.56 20%
Bayer BAYN GY          79.07 21%
BMW BMW GY          62.00 17%
Duerr DUE GY            1.75 39%
EADS EAD FP          39.13 29%
Henkel HEN GY          34.96 15%
KUKA KU2 GY            1.51 24%
MAN MAN GY          17.48
Rolls Royce RR/ LN          28.61
Volkswagen VOW GY        108.79 14%
Zodiac ZC FP            6.46

Because of its Airbus division which competes with Boeing, EADS may be of particular interest to US readers. Last year, I wrote about the epic battle between the two aircraft manufacturers in Boeing vs. Airbus: Orders and Profits. Since then, EADS has undergone some important changes in its shareholding structure. Its free float which is now 54% is expected to rise above 70% after large legacy shareholders reduce their stakes. Management has expressed a new commitment to transform the company from a conglomerate of state-owned or state-sponsored businesses into a more ‘normal’ company which is more responsive to shareholders.

Finally, Europe has some outstanding companies in the mass-market consumer and retail sector which expect to grow in emerging markets as well as in the United States.  Notable among them are Hennes & Mauritz and Inditex, the parents of retailers H&M and Zara, and cosmetics giant L’Oreal.

 Consumer/Retail     Market Cap   AsiaPac % 
     Billions USD   2011 Sales 
 Adidas  ADS GY           19.63 16%
 BAT  BATS LN         100.55 28%
 Beiersdorf  BEI GY           22.32
 Bic  BB FP             5.78
 Hennes & Mauritz  HMB SS           60.76
 Hugo Boss  BOSS GY             8.47
 Inditex  ITX SM           88.35
 L’Oreal  OR FP           91.98
 Nestle  NESN VX         226.60
 Unilever  UNA NA         118.07 41%

What Europe does not have

Outside of indexing and macro driven investing, what about simple bottom-up investing?  Ideally, we would like to invest in names which are insulated from the big macro questions of US and China growth.  However, it is difficult to imagine many large or midsized European stocks doing well in the event of a Chinese slowdown and US recession.  Under this scenario, it would be best to find a handful of smaller names with their own domestic growth dynamic.

Yet, if this seems like a desirable strategy, the US market is more fertile ground to find such small companies for two reasons: 1) the US has more new companies which go public and 2) these companies can grow domestically for longer because the size of the domestic market is many times larger. A good example is Whole Foods (WFM) which was still a small cap name in 2000 (and again briefly in late 2008). It now has over 300 stores in the United States (and 15 in Canada and the UK) and added ten new stores in the last quarter, eight of which were in the US. A similar European company would have hit the wall in its home market at a much earlier stage.  Outside of the large trends described above, there is, in my view, little reason for a US-based investor to put money in a small European company unless it is really a very unique and irresistible story with no US equivalent.

The clear Nordic air

The clear Nordic air

You might think that Nokian Tyres fits that profile. But even here, much of the company’s growth is directly linked to demand from Russia, which is itself tied to the rise in energy prices and ultimately, to the growth of the Chinese economy.  Should that economy slow down, the price of oil would decline which would dampen Russian demand for all sorts of goods, including tires.  Because European companies have a smaller domestic market than their US counterparts, it is more difficult to find good secular growth stories which are not dependent on the global growth picture.

If we redefine a company’s domestic market as the whole of Europe instead of just its home country, we find a handful of steady growth names. A notable pan-European success is the Swedish retailer Hennes & Mauritz which has 406 H&M stores in Germany, 226 in the UK, 182 in France, 177 in Sweden and hundreds of others elsewhere. It also has 269 in the US (from none in 1999) and 111 in China. H&M is among a handful of retailers that have gained market share in several markets (another is Inditex’s Zara). Today, the company’s growth is very much tied to globalization given that its cash flow (and ability to invest) is derived from a very high gross margin, the result of sourcing its products from 700 independent suppliers mostly in Asia. Hennes’ gross margin has expanded from 44.6% in 1998-99 to a blistering 59.5% in 2012 (it was over 60% in 2010-11). As a comparison, Gap’s gross margin in 2011 was 36.2%, down from 45.3% in 1999.

Other interesting growth companies include food caterers Compass (CPG LN) and Sodexho (SW FP), eye lens maker Essilor (EF FP), lock manufacturer Assa Abloy (ASSAB SS), diabetes care leader Novo Nordisk (NOVOB DC), health product suppliers Coloplast (COLOB DC) and Getinge (GETIB SS) and oil services companies Technip (TEC FP), TGS Nopec (TGS NO) and Seadrill (SDRL NO).  Yet they all seem in varying degrees to have grown to their current size because of demand from outside Europe. I maintain that the odds of finding several small or mid cap stocks which will grow year after year from domestic demand alone are significantly lower than in the US.

Europe also does not have a large investable technology sector. Among larger companies, there are SAP (SAP GY) and ASML (ASML NA). Every country has a smattering of smaller companies which operate in services or in manufacturing niches.  What some Europeans call technology tends to be larger scale and sometimes state-sponsored, an R&D effort which may very well be on the cutting edge but which has more to do with machinery and engineering than with computers, data processing or the internet. This includes high speed trains and nuclear plants where the French are leaders. Perhaps there will be another new technology where European companies will take a lead, but if the history of mobile phones is an indication, this leadership will probably be short-lived.

The conclusion is two-fold:  1) the main reason to invest in Europe has in recent years been non-European demand for some superior products and 2) Europe has been the first place to see early signs of an emerging crisis. One has to approach European investing with a macro perspective developed elsewhere, by analyzing demand in the US and China, and then choose the global leaders which are best leveraged to that macro perspective. Obviously, this could work in reverse with a vengeance.  Any evidence of a prolonged Chinese slowdown would tumble some luxury goods and industrial stocks by 20%, 30% or more.

Because Europe is now in recession, a recovery would certainly result in a cyclical upturn in earnings for many companies. Value investors today should be sifting through the long list of beaten down names, among them the long suffering French volume auto producers Peugeot (UG FP) and Renault (RNO FP). But European demographics are poor and cannot contribute a sustained source of demand.  This means that, beyond the cyclical recovery, the longer term growth driver for most European equities will still have to come from outside Europe.

On ‘America’s Baby Bust’


(also published at Seeking Alpha)

Jonathan Last’s recent article in The Wall Street Journal is sufficiently alarmist and buzz-generating to please his agent and publisher on the eve of the release of his book What to Expect When No One’s Expecting, with the doom and gloom tagline America’s Coming Demographic Disaster.  ‘No One’ is an exaggeration since there were about 4 million births in the US last year, but I understand the appeal of using a title which is reminiscent of Heidi Murkoff’s blockbuster book on pregnancy.  As to the phrase ‘Coming Demographic Disaster’, it could put Last, years from now, in the category of pessimistic forecasters who were proven spectacularly wrong, alongside Paul Ehrlich, author in 1968 of The Population Bomb. Forecasting is a difficult task and extrapolating the known past and present into the future has often proved to be an inadequate approach.  There are usually new hitherto unknown factors which intervene down the road and which derail any linear or semilinear prediction.

However, none of this should diminish the fact that Last’s article is an excellent must-read for anyone who still believes that US demographics are strong and supportive of future economic growth.  As I wrote a few months ago, there are many, including many in leadership positions, who still live with this illusion. Last’s main point is absolutely correct.  The birth rate (and fertility rate) has declined since the 1970s and the growth rate of the US population has been on a downward trend.  This phenomenon yielded a large demographic dividend from about 1982 to 2005, but it is now leading to large negative consequences for the economy. I covered several of these points in previous articles on this site. Most critical in my view is the rise in the dependency ratio which is likely to last now for several decades.  US demographics provided steady tail winds to the US economy for decades and added a large demographic dividend when the birth rate fell and more women joined the work force, but we are now over that hill and are facing intensifying demographic head winds.

I differ with Last on his recommendation that we need more children now.  Children born now will not contribute to the economy for another twenty years and their numbers will only further exacerbate an already climbing dependency ratio.  We cannot rewrite the past but what we need now are more adults in their 20s, 30s and 40s, in other words more children born in the 1970s, 80s and 90s.  Yet, had we had these children back then, the economy would not have been as strong in the 1980s and 1990s because less capital would have been available for saving and investing.  In many ways, we front-loaded demand, saving, investment and prosperity in those two decades and now face some inverse complications.

All is not lost however. Instead of boosting the birth rate now, a four-point solution would include 1) raising the age of eligibility for Social Security and Medicare, 2) improving labor force participation, 3) continued innovation and 4) more exports.  The first two would slow, delay or neutralize the rise in the dependency ratio.  Innovation is the most important driver of the economy but innovation without a large demographic audience does not achieve its full wealth creating potential.  An iPhone introduced to a market of 3 billion people clearly will create more wealth than an iPhone introduced to a market of 30 million people. Because US demographics are getting weaker and US demand will be less strong than in the past, an obvious solution is to look for new sources of demand outside our borders.  For this reason, it is essential that the US cultivates new export markets, in particular in countries with attractive demographic profiles.  As I wrote in this article, these markets are chiefly India and the countries of SubSaharan Africa, notably Nigeria, Tanzania and Uganda where the population is large and the fertility ratio is expected to decline, raising the possibility of a demographic dividend in coming decades.  This dividend is not guaranteed to happen. It is only a window of opportunity which opens and closes. And countries are able to capitalize on it only if they strengthen their institutions and improve their governance and transparency.